The Smart Profits Report: Issue #129
Monday, July 26th, 2004 Covered Calls and Put Options: How to Grow Your Equity By Going Naked
By Karim Rahemtulla
Investment Director, Mt. Vernon Research When I speak on covered call writing, someone from the audience will often chime in and ask about "the difference between writing covered calls and put options selling." Is it the same thing as covered call writing? Yes and no. There are distinct differences, advantages and disadvantages to both. But to understand how selling put options works, let's quickly revisit covered calls... Covered Call Writing, Puts and IBM... As I mentioned in a previous Smart Profits Report, covered call writing entails buying shares of a company and selling an option against those shares, effectively reducing cost by the amount you are paid for the option you sell. The covered call investing strategy is best for those who believe that the upside potential of the shares is limited, or when a disciplined approach to investing dictates that the shares will be sold once a preset target price is reached. Selling puts works like this: Say you like the shares of IBM, which are currently at $92. You think the stock is worth that and more, but the stock seems likely to fall. Instead of buying the shares at $92 and selling a $95 call option against your position, as we would have with a covered call, this time you don't buy the shares at all... You SELL a $90 put option, naked (meaning you don't own the underlying shares). The premium on this put, for the sake of this example, is $2.50. Immediately, you receive $2.50 per share in your account to use as you please - free money, for now. So You've Pocketed a Nice Sum... But the Trade's Not Over But you still have an obligation lingering. If IBM closes above $90, the money is yours, free and clear. Nobody is going to "put" the stock to you at $90 if it's worth more on the open market. But if IBM closes BELOW $90, then you are OBLIGATED to buy IBM shares at $90. This is called "getting put." The only way out is to buy back the put. In fact, when you sell naked puts, you'll be making money even if the shares drop a bit. As long as IBM's price is above $87.50 ($90 strike minus the $2.50 premium), you are profitable. But, if the shares close below $87.50, then you are losing money. So, in a sense you are betting the shares will stay above $87.50 until expiration. This is a very popular strategy for many investors because it does not require you to own the shares, so you don't have all that money at risk. You are required, however, to have enough money in your margin account to buy the shares in the event you are "put." How to Avoid a Serious Investing "Put" Fall Getting put is not pleasant, unless you REALLY want to own the shares. Imagine waking up one day and hearing that IBM shares have fallen by 20%, to $75, because of a scandal or bad earnings. If the shares do not recover and the option expires, you must either buy the shares at $90 or buy back the option that you sold - a big loss in either case. Now, I have nothing against put selling. In fact, I think it is an excellent strategy if you are disciplined, have the money and are genuinely interested in owning the shares at your strike price. But that's not the case with most investors. While selling puts is as conservative as covered call writing "selling" - in theory - either strategy can be misused. And this one usually is. Gambling, Greed and Abusing Your Put Power Instead of evaluating a stock realistically, traders sometimes look at put selling as "free" money, betting that the price of the company's shares will not fall below their strike price. Instead of having the money or the investment base to sustain a major hit, they're just trying to make a quick buck. That's gambling, and it's a recipe for disaster - especially true with a volatile stock like Yahoo! or Amazon. With companies like those, the put premium is huge - reflecting the underlying volatility in price. That huge premium is a lure for many investors. And why not? There is a ton of money to be made... unless the shares really tank. But this is exactly the kind of greed that gives selling naked puts a bad reputation. The major advantage of selling puts is being able to pursue a conservative strategy with less money. The major disadvantages are: - You cannot sell puts in your retirement account.
- You do not receive dividends, because you don't own the shares.
The first disadvantage is the most important. I like covered call writing because the gains from the trades are tax-deferred, since I can trade them in my retirement account. This is a key differentiator between a covered call investing strategy and selling puts. A Great Way to Build Equity for Small Investors Still, put selling is a powerful tool. It is one of the most conservative options trading strategies, if executed properly. If you are just starting out and have a smaller portfolio, it is an effective way to build up equity. But you must have the same discipline as a trader using any other system. You must have a stop loss in place, you must position size and you must do your homework about the investment. Good Trading, Karim Rahemtulla Today's Smart Profits Cribsheet - Check out our Smart Profits Glossary for detailed explanations of options-trading terms such as "covered calls" and "naked options."
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